MODULE 3

ACCOUNTING AND INFORMATION SYSTEM

SESSION TOPIC 3: Ethics, Fraud and Internal Control

LEARNING OUTCOMES:
The following specific learning objectives are expected to be realized at the end of the session:
1. Broad issues pertaining to business ethics
2. Ethical issues related to the use of information technology
3. Distinguish between management fraud and employee fraud
4. Common types of fraud schemes
5. Key features of COSO internal control framework
6. Objects and application of physical controls

KEY POINTS

Business Ethics Management Fraud Employee Fraud Fraud Schemes

COSO Internal Control Physical Controls
Framework

CORE CONTENT
Introduction:

This module examines three closely related areas of concern, which are specifically addressed by the Sarbanes-Oxley
Act (SOX) and are important to accountants and management. These are ethics, fraud, and internal control. We begin the
chapter by surveying ethical issues that highlight the organization’s conflicting responsibilities to its employees,
shareholders, customers, and the general public. Organization managers have an ethical responsibility to seek a balance
between the risks and bene- fits to these constituents that result from their decisions. Management and accountants must
recognize the new implications of information technologies for such historic issues as working conditions, the right to
privacy, and the potential for fraud. The section concludes with a review of the code of ethics requirements that SOX
mandates.

The second section is devoted to the subject of fraud and its implications for accountants. Although the term fraud is very
familiar in today’s financial press, it is not always clear what constitutes fraud. In this section, we discuss the nature and
meaning of fraud, differentiate between employee fraud and management fraud, explain fraud-motivating forces, review
some common fraud techniques, and outline the key elements of the reform framework that SOX legislates to remedy
these problems.

The final section in the chapter examines the subject of internal control. Both managers and accountants should be
concerned about the adequacy of the organization’s internal control structure as a means of deterring fraud and
preventing errors. In this section, internal control issues are first presented on a conceptual level. We then discuss internal
control within the context of the Statement on Auditing Standards no. 78/ Committee of Sponsoring Organizations of the
Treadway Commission (SAS 78/COSO) framework recommended for SOX compliance.

IN-TEXT ACTIVITY

Business Ethics involves finding the answers to two questions:

— How do managers decide on what is right in conducting their business?
— Once managers have recognized what is right, how do they achieve it?

Why should we be concerned about ethics in the business world?

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 — Ethics are needed when conflicts arise—the need to choose
— In business, conflicts may arise between:
— employees
— management
— stakeholders
— Litigation

Computer Ethics concerns the social impact of computer technology (hardware, software, and telecommunications).

Computer Ethics Issues:

§ Privacy
§ Security—accuracy and confidentiality
§ Ownership of property
§ Equity in access
§ Environmental issues
§ Artificial intelligence
§ Unemployment and displacement
§ Misuse of computer

FRAUD

— False representation - false statement or disclosure

— Material fact - a fact must be substantial in inducing someone to act
— Intent to deceive must exist
— The misrepresentation must have resulted in justifiable reliance upon information, which caused someone to act
— The misrepresentation must have caused injury or loss

Enron, WorldCom, Adelphia

— Lack of Auditor Independence: auditing firms also engaged by their clients to perform nonaccounting activities
— Lack of Director Independence: directors who also serve on the boards of other companies, have a business trading
relationship, have a financial relationship as stockholders or have received personal loans, or have an operational
relationship as employees
— Questionable Executive Compensation Schemes: short-term stock options as compensation result in short-term
strategies aimed at driving up stock prices at the expense of the firm’s long-term health.
— Inappropriate Accounting Practices: a characteristic common to many financial statement fraud schemes.
— Enron made elaborate use of special purpose entities
— WorldCom transferred transmission line costs from current expense accounts to capital accounts

Sarbanes-Oxley Act of 2002

Its principal reforms pertain to:
— Creation of the Public Company Accounting Oversight Board (PCAOB)
— Auditor independence—more separation between a firm’s attestation and non-auditing activities
— Corporate governance and responsibility—audit committee members must be independent and the audit committee
must oversee the external auditors
— Disclosure requirements—increase issuer and management disclosure
— New federal crimes for the destruction of or tampering with documents, securities fraud, and actions against
whistleblowers

Employee Fraud
— Committed by non-management personnel
— Usually consists of: an employee taking cash or other assets for personal gain by circumventing a company’s system
of internal controls

Management Fraud

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 — Perpetrated at levels of management above the one to which internal control structure relates
— Frequently involves using financial statements to create an illusion that an entity is more healthy and prosperous than
it actually is
— Involves misappropriation of assets, it frequently is shrouded in a maze of complex business transactions

Fraud Schemes

Three categories of fraud schemes according to the Association of Certified Fraud Examiners:
A. fraudulent statements
B. corruption
C. asset misappropriation

FRAUDULENT STATEMENTS
— Misstating the financial statements to make the copy appear better than it is
— Usually occurs as management fraud
— May be tied to focus on short-term financial measures for success
— May also be related to management bonus packages being tied to financial statements

CORRUPTION
— Examples:
— bribery
— illegal gratuities
— conflicts of interest
— economic extortion
— Foreign Corrupt Practice Act of 1977:
— indicative of corruption in business world
— impacted accounting by requiring accurate records and internal controls

ASSET MISAPPROPRIATION
— Most common type of fraud and often occurs as employee fraud
— Examples:
— making charges to expense accounts to cover theft of asset (especially cash)
— lapping: using customer’s check from one account to cover theft from a different account
— transaction fraud: deleting, altering, or adding false transactions to steal assets

COMPUTER FRAUD SCHEMES

— Theft, misuse, or misappropriation of assets by altering computer-readable records and files
— Theft, misuse, or misappropriation of assets by altering logic of computer software
— Theft or illegal use of computer-readable information
— Theft, corruption, illegal copying or intentional destruction of software
— Theft, misuse, or misappropriation of computer hardware

Data Collection Fraud

— This aspect of the system is the most vulnerable because it is relatively easy to change data as it is being entered
into the system.
— Also, the GIGO (garbage in, garbage out) principle reminds us that if the input data is inaccurate, processing will result
in inaccurate output.

Data Processing Fraud

Program Frauds
— altering programs to allow illegal access to and/or manipulation of data files
— destroying programs with a virus

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Operations Frauds
— misuse of company computer resources, such as using the computer for personal business

Database Management Fraud

— Altering, deleting, corrupting, destroying, or stealing an organization’s data
— Oftentimes conducted by disgruntled or ex-employee

Information Generation Fraud – Stealing, misdirecting or misusing computer output.

Scavenging
— searching through the trash cans on the computer center for discarded output (the output should be shredded, but
frequently is not)

INTERNAL CONTROL OBJECTIVES

1. Safeguard assets of the firm

2. Ensure accuracy and reliability of accounting records and information
3. Promote efficiency of the firm’s operations
4. Measure compliance with management’s prescribed policies and procedures

Modifying Assumptions to the Internal Control Objectives

— Management Responsibility
The establishment and maintenance of a system of internal control is the responsibility of management.

— Reasonable Assurance
The cost of achieving the objectives of internal control should not outweigh its benefits.

— Methods of Data Processing

The techniques of achieving the objectives will vary with different types of technology.

LIMITATIONS OF INTERNAL CONTROLS

— Possibility of honest errors
— Circumvention via collusion
— Management override
— Changing conditions--especially in companies with high growth

EXPOSURES OF WEAK INTERNAL CONTROLS (RISK)

— Destruction of an asset
— Theft of an asset
— Corruption of information
— Disruption of the information system

COSO
Describes the relationship between the firm’s…
— internal control structure,
— auditor’s assessment of risk, and
— the planning of audit procedures
How do these three interrelate?

The weaker the internal control structure, the higher the assessed level of risk; the higher the risk, the more auditor procedures
applied in the audit.

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Five Internal Control Components
1. Control environment
2. Risk assessment
3. Information and communication
4. Monitoring
5. Control activities

Control Environment
— Integrity and ethics of management
— Organizational structure
— Role of the board of directors and the audit committee
— Management’s policies and philosophy
— Delegation of responsibility and authority
— Performance evaluation measures
— External influences—regulatory agencies
— Policies and practices managing human resources

Risk Assessment
— Identify, analyze and manage risks relevant to financial reporting:
— changes in external environment
— risky foreign markets
— significant and rapid growth that strain internal controls
— new product lines
— restructuring, downsizing
— changes in accounting policies

Information and Communication

— The AIS should produce high quality information which:
— identifies and records all valid transactions
— provides timely information in appropriate detail to permit proper classification and financial reporting
— accurately measures the financial value of transactions
— accurately records transactions in the time period in which they occurred
— Auditors must obtain sufficient knowledge of the IS to understand:
— the classes of transactions that are material
— how these transactions are initiated [input]
— the associated accounting records and accounts used in processing [input]
— the transaction processing steps involved from the initiation of a transaction to its inclusion in the financial
statements [process]
— the financial reporting process used to compile financial statements, disclosures, and estimates [output]

Monitoring
The process for assessing the quality of internal control design and operation
[This is feedback in the general AIS model.]
— Separate procedures—test of controls by internal auditors
— Ongoing monitoring:
— computer modules integrated into routine operations
— management reports which highlight trends and exceptions from normal performance

Control Activities
— Policies and procedures to ensure that the appropriate actions are taken in response to identified risks
— Fall into two distinct categories:
— IT controls—relate specifically to the computer environment
— Physical controls—primarily pertain to human activities

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Two Types of IT Controls:
— General controls—pertain to the entitywide computer environment
— Examples: controls over the data center, organization databases, systems development, and program
maintenance
— Application controls—ensure the integrity of specific systems
— Examples: controls over sales order processing, accounts payable, and payroll applications

Six Types of Physical Controls

1. Transaction Authorization
2. Segregation of Duties
3. Supervision
4. Accounting Records
5. Access Control
6. Independent Verification

PHYSICAL CONTROLS

1. Transaction Authorization
 used to ensure that employees are carrying out only authorized transactions
 general (everyday procedures) or specific (non-routine transactions) authorizations

2. Segregation Duties
In manual systems, separation between:
 authorizing and processing a transaction
 custody and recordkeeping of the asset
 subtasks
In computerized systems, separation between:
 program coding
 program processing
 program maintenance

3. Supervision – a compensation for lack of segregation; some may be built into computer systems

4. Accounting Records – provide an audit trail

5. Access Controls – help to safeguard assets by restricting physical access to them

6. Independent Verification - reviewing batch totals or reconciling subsidiary accounts with control accounts

Physical Controls in IT Contexts

1. Transaction Authorization
The rules are often embedded within computer programs.
 EDI/JIT: automated re-ordering of inventory without human intervention

2. Segregation Duties
 A computer program may perform many tasks that are deemed incompatible.
 Thus the crucial need to separate program development, program operations, and program maintenance.

3. Supervision – The ability to assess competent employees becomes more challenging due to the greater technical
knowledge required.

4. Accounting Records – ledger accounts and sometimes source documents are kept magnetically

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 5. Access Control – Data consolidation exposes the organization to computer fraud and excessive losses from disaster.

6. Independent Verification
 When tasks are performed by the computer rather than manually, the need for an independent check is not
necessary.
 However, the programs themselves are checked.

SESSION SUMMARY

This module began by examining ethical issues that societies have pondered for centuries. It is increasingly apparent
that good ethics is a necessary condition for the long-term profit- ability of a business. This requires that ethical issues
be under- stood at all levels of the firm, from top management to line workers. In this section, we identified several
ethical issues of direct concern to accountants and managers. SOX legislation has directly addressed these issues.

The next section examined fraud and its relationship to auditing. Fraud falls into two general categories: employee fraud
and management fraud. Employee fraud is generally designed to convert cash or other assets directly to the employee’s
personal benefit. Typically, the employee circum- vents the company’s internal control structure for personal gain.
However, if a company has an effective system of internal control, defalcations or embezzlements can usually be pre-
vented or detected. Management fraud typically involves the material misstatement of financial data and reports to
attain additional compensation or promotion or to escape the penalty for poor performance. Managers that perpetrate
fraud often do so by overriding the internal control structure. The underlying problems that permit and aid these frauds
are frequently associated with inadequate corporate governance. In this section we examined some prominent
corporate governance failures and outlined the key elements of SOX, which was legislated to remedy them. Finally,
several well-documented fraud techniques were reviewed.

The third section examined the subject of internal control. The adequacy of the internal control structure is an issue of
great importance to both management and accountants. Internal control was examined first using the PDC control
model that classifies controls as preventive, detective, and corrective. Next, the SAS 78/COSO framework recommended
for compliance with SOX was examined. This consists of five levels: control environment, risk assessment, information
and communication, monitoring, and control activities. In this section, we focused on physical control activities including
trans- action authorization, segregation of duties, supervision, adequate accounting records, access control, and
independent verification.

SELF-ASSESSMENT

Assignment: (Group)

Case Study:

FV Corporation is a new corporation providing food services in Molino. Due to financial constraint, they hired
BBMI as their outsourced accounting process. It turned out that BBMI was also hiring another accountant who prepares
the financial statements for FV Corporation. It turned out that no accounting department is maintained by BBMI and all
data are being summarized by one person.

During audit, it was determined that all information was incorrect. The auditor assessed that the misstatements
were due to fraud or error, as the outsourced accountant is the brother of BBMIs Vice President.

Assume you are the consultant of BBMI, prepare a Risk and Control Matrix to improve the internal controls of FV
Corporation to address the risks of misstatements due to fraud or error.

In your Risk and Control Matrix, you must determine potential risks and controls for the following processes only:
 Revenue Process

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  Expenditure Process

Quiz: Multiple choice.

REFERENCES
Refer to the references listed in the syllabus of the subject.

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